Thursday, April 3, 2008

Commoditization: our own damn fault

Over the past two weeks, I’ve been reminded (often painfully) of the origins and consequences of commoditization, in the disparate segments of computer components, musical instruments and airlines. All tie back in some way to consumer decisions that fuel price competition and thus globalization.

Computers. On March 25, the hard disk died on my laptop, ruining the rest of my spring break and most waking moments since. It was a two year old third party drive that I installed on my 6-year-old PowerBook, and it died without warning as I was downloading some e-mail outside the Oceanside library.

When I got home, I began the laborious process of restoring data from backups on two external drives made by Seagate and Western Digital, complicated by the drives not working reliably with my host computer. (Is this due to faulty interfaces in the drive? In the computer? I can’t tell).

For both the external disk drives, I bought something cheap when I had the opportunity. Of course, I bought these drives to be reliable sources of backups when I really needed it (i.e. now). As I whined to friends and strangers over the past 10 days, someone pointed out that it’s quite possible for companies to make computers that would last 5 or 10 years, but nobody would pay the price. In fact, Google’s (and other) server farms have been architected to use cheap unreliable blade computers, and to throw them away rather than fix them.

Musical Instruments. While in Oceanside, my daughter picked up a used Gemeinhart starter flute to use for her second year of flute lessons. In asking around, experts told us not to buy a new Gemeinhardt flute in that category, because the quality of these Chinese-made flutes is not as good as the ones that they used to sell 10 or 15 years ago. While this may be a direct globalization effect, globalization is really a response to broader commoditization pressures.

The exact same arguments were made about Fender guitars (Stratocaster, Telecaster, Precision Bass) after the owners sold out to CBS in 1965, and CBS cut costs and ramped up production to get growth by reaching a wider market. For decades you could find advertisements for used “pre-CBS” guitars which were held to be superior to those produced by the conglomerate.

Unlike most firms, Fender got really clever about this and gave consumers a choice. If you walk into Guitar Center (the big box store that itself fuels commoditization) or online to Musician’s Friend (ditto), you can buy a U.S. Fender, Mexico or an Asian-made cheapo.

Fender and the rest of the guitar industry segmented their line into the crappy and main product lines. For starter users, Fender has Squier, Gibson has Epiphone, Warwick has RockBass and Washburn has Lyon. This means that teenagers just starting out can get a guitar at Costco for $100 or a full kit (with amp) at Amazon for $200, while working professionals (or middle aged garage musicians who really care about quality) can buy an American guitar for 5x or 10x that.

Airlines. Airline maintenance problems have been in the news recently, and disgruntled unions have attributed the problems to offshoring of repair work (which is not completely true since Southwest had the first and most serious problems, and they don’t offshore anything).

However, the issue has been brought home to me because I’ve passed through SJC Terminal A four times in the past eight days, including this morning at the ungodly hour of 6am. This is the home of Southwest and American, the two airlines that fly to San Diego, and thus a familiar sight during the period we were winding down Palomar Software while living up here.

What was shocking was to see last week how American has beat a retreat out of San Jose, the hub that it inheirited with its 1999 purchase of Reno Air. This week Terminal A 8 gates for Southwest, 6 for AA and 2 unused; a year ago, it was 6 gates for WN and 10 for AA.

Some have said deregulation was a failure. That’s b.s. (and I don’t mean Barbra Streisand). Deregulation did exactly what it said it would do: increase consumer choice and reduce prices. My first flight to MIT in 1975 cost $400, and before the collapse of the dollar pushed up oil prices, you could buy that same transcontinental ticket in today’s competitive market for $102 in 1975 dollars (after adjusting for inflation).

That’s not to say that deregulation is without consequences, one of which is that airlines go under. This morning’s paper said that Alitalia may be going under, because the government can’t square its protectionism (against foreign takeover) and desire to preserve Italian jobs with the fact that bloated inefficient carriers will lose millions if not billions in today’s competitive market.

In the US, two recent examples include Aloha and TWA. On Monday, 61-year-old Aloha threw in the towel because it couldn’t compete with low-cost go! owned by Mesa Airlines (after two years of whining). However, for the first time in decades (if ever) Hawaiian consumers had real competition on inter-island fares that those of us in California and Texas (with cars as substitutes) have enjoyed for decades.

This morning I got on a DC-9 (aka Super-80) flight to St. Louis for a conference. AA didn’t own any DC-9s until its 2001 purchase of TWA, Howard Hughes’ onetime global flagship of luxury travel that was no longer protected by CAB-padded fares after dereguation. After after AA bought TWA, this flight remained a nonstop to TWA’s longtime hub in St. Louis, but last July AA closed that hub, so today I had to get up two hours earlier to detour via Chicago.

Analysis. Commoditization is real, and irreversible. It has good and bad consequences.

“Consumer” advocates (often funded by unions) often want to use regulation to restrict entry or push up costs. Certainly airlines and drugs and auto restraints need to be regulated for life-and-death reasons, but that shouldn’t be a smokescreen for other forms of regulation that distort the marketplace to help those who have the ear of politicians.

I think the guitar example is the best example of markets at work. Consumers have full choices and there seems to be a well-developed market of people who will pay a premium for better products.

Sometimes we don’t have accurate quality information, but even if we do, there’s a limit to how much of a premium such quality commands. If I knew that one hard disk was more reliable than the other, then I'd be interested in paying a premium, but I might not buy the more reliable model. If it’s too expensive, I would use a RAID drive that assumes spindles will fail, or go to a hosted service (such as that guarantees reliability.

Europeans claim that Americans have bias towards cheap over all other. That might be true, but in other cases short-term thinking can make sense: you get what you pay for and sometimes what you want is cheap.

But thinking short-term and buying the cheapest product is always an individual choice. For a wedding gift 16 years ago, my wife asked for a KitchenAid mixer; since then we have given away at least three as a wedding gifts (plus a fourth to our goddaughter). Yes, in these Wal-Mart days it seems strange to pay $200-$300 for an appliance, but my mother-in-law has been using the same mixer for 40 years and Elizabeth hopes to say the same thing to her own daughter.

Airlines are a little more problematic. AA has almost given up on San Jose because (like everywhere else) people are flying Southwest. If they can both take you 500 miles in an hour and a half, is it illogical to expect to pay the same price? No. The problem is, with its union salaries and work rules, AA can’t break even unless it can sell seats at the higher price — and on routes where it competes with Southwest, it rarely can.

Buyers can say they will pay more for something that save high-wage jobs, but they never actually do it. However, at least some buyers will pay a premium if they get more — better quality, reliability, performance, status. The American-made Telecaster or my iPod are two examples. Of course, maintaining an advantage over commodity products is a never-ending battle.

Commoditization is changing nearly every industry, and businesses need to deal with it. Chris Anderson (of Long Tail fame) is writing articles and doing a book about the ultimate level of commoditization: Free. I look forward to critiquing it.

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